Social Preferences and Incentives in OrganizationsSocial Preferences and Incentives in Organizations...

Social Preferences and Incentives in Organizations

Workshop by Jenny Kragl

EBS University of Business & Law, Wiesbaden, Germany

Institutional and Organizational Economics Academy17th Session, 21-25 May 2018

Cargèse, Corsica

Jenny Kragl (EBS) Workshop (IOEA) May 24, 2018 1 / 69

Contents

Individual employment relationships are typically embedded in the largerframework of organizations such as firms, thus in a social context wheremutual comparisons may play a role. Empirical evidence suggests that workersnot only care about their absolute but also their relative economic positioncompared to co-workers or peers. In the last decades, a large body of literaturehas evolved that is concerned with social (or other-regarding) preferences ingeneral and in regard to their effects on economic performance, wellbeing, andthe motivation of workers.

In this workshop, we will discuss selected theoretical approaches to modelincentive provision for other-regarding actors in the context of organizations.We will consider different incentive schemes such as individual, joint, andrelative performance pay both in one-shot and repeated settings. This allowsto reconsider optimal incentive schemes in organizations and sheds light onobserved features of real-life incentive schemes.


Incentive Theory

“Traditional”models have studied (not only) ...

... the optimal design of incentives within firms (and between).


Incentive Theory

“Traditional”models have studied a plethora of different topics ...

ex-ante vs. ex-post asymmetric information

performance pay (individual, joint, relative)

explicit vs. implicit incentives

one-shot vs. repeated contracts

one-task vs. multitasking settings, job design

risk aversion, limited liability, wealth constraints

bilateral vs. multilateral relationships

hierarchies and organizational structure

...


Incentive Theory

“Traditional”models have focused on ...

... actors with purely self-regarding preferences.


Relative Pay Concerns

However ...



Relative pay matters ...

... in particular in the workplace.



Thanks to Johannes Martin for the cartoon.


Behavioral Economics

Neoclassical Economics

presumption: by and large, people act rationally (i.e., deviationsfrom perfect rationality are so small or so unsystematic as to benegligible)

⇒ actors can be approximated by a homo economicus, who is arational, purely self-interested utility or profit maximizer

Behavioral Economics

attempt to increase the explanatory and predictive power ofeconomic theory by providing it with more psychologically plausiblefoundations

⇒ presumption: deviations from rationality and pure self-interest arelarge or systematic enough to warrant the development of new(descriptive) theories of decision


Social Preferences: Evidence

empirical evidence suggests that relative pay comparisonsstrongly affect individual satisfaction

horizontal income comparisons occur among peers, e.g., co-workers

Card, Mas, Moretti, and Saez (2010): U of CaliforniaClark and Oswald (1996): British workersMayraz, Schupp, and Wagner (2009): German households

vertical income comparisons occur across different hierarchicallevels, e.g., between workers and firm owners

Agell and Lundborg (1995): Swedish manufacturing companiesBewley (1999): large-scale interviews (business executives, laborleaders, professional recruiters, ...)Blinder and Choi (1990): HR managers in New Jersey andPennsylvania


Social Preferences: Evidence

experimental evidence from the laboratory is inconsistent withpurely selfish behavior

systematic resultsdictator game: proposers offer 10-30% (rather than zero)ultimatum game: proposers offer 30-50% on average, respondersreject low offers (below 20% half of the time)

volunteers voluntarily accept huge opportunity cost in terms offorgone salaries

non-profit organizations, social businesses, charitable foundationsstate goals different from profit maximization

examples of social preferences (as to income comparison): envy,compassion, altruism, spitefulness, status-seeking


Social Preferences: Models

models of social preferences presume that others’income,behavior, or intentions may affect individual utility

such preferences are also called other-regardinghere are some well-known theory contributions:

Rabin (1993): fairnessDufwenberg and Kirchsteiger (2004): reciprocityBolton and Ockenfels (2000): equity, reciprocity, and competitionFalk and Fischbacher (2006): reciprocityFehr and Schmidt (1999): inequity aversion (envy, compassion)

experimental evidence often in line with envy or inequity aversion

neural evidence for inequality aversion (Tricomi et al. 2010)

most of the (behavioral) agency literature (and this workshop)focuses on inequity aversion and envy


Inequity Aversion

xi denotes the monetary payoff of player i ∈ 1, ..., nx = x1, ..., xn is the vector of monetary payoffs

utility function of player i :

Ui (x) = xi − αi1

n− 1 ∑j 6=imaxxj − xi , 0 − βi

1n− 1 ∑

j 6=imaxxi − xj , 0

where 0 ≤ βi < 1 and αi ≥ βi⇒ self-centered inequity aversion

xi > xj : advantageous inequalityxi < xj : disadvantageous inequality

inequitable payoffs lead to utility losses ⇒ player i is willing to giveup money to achieve a more equitable payoff distribution


Inequity Aversion

utility function of player i :

Ui (x) = xi − αi1

n− 1 ∑j 6=imaxxj − xi , 0 − βi

1n− 1 ∑

j 6=imaxxi − xj , 0

αi ≥ 0 measures player i’s propensity for envyβi ≥ 0 measures player i’s compassion(βi < 0 represents joy of outperforming)

βi < 1: players don’t burn money

αi ≥ βi : envy is the stronger social emotion

for n = 2, we obtain:

Ui (xi , xj ) = xi − αi maxxj − xi , 0 − βi maxxi − xj , 0, i 6= j


Inequity Aversion and Incentive Pay

individual employment relationships are typically embedded inthe framework of the firm

firm is a social context where pay comparison may play a roleincentive pay is an important source of wage inequalityextent of pay inequality depends on the incentive scheme

→ important types of incentive pay:

individual: depends on individual performance onlyjoint: positively depends on peer’s performancerelative: negatively depends on peer’s performance

⇒ if the presence of other-regarding preferences affects theeffectiveness of incentive pay, firms should be aware of it

implications for optimal incentive schemes

implications for organizational architecture of the firm


Outline

in the last two decades, multiple theoretical (and empirical) studieshave been presented in the field of behavioral economics

we will focus on (just a few in) simple principal-agent settings

simple examples of individual, joint, and relative incentive pay

introduce the models but focus on economic intuition (no proofs)

we first review some basic results in one-shot games

then we study more recent work

the following slides are mostly based on:

Bental and Kragl (mimeo)Demougin and Fluet (2003)Gogova and Kragl (2013)Grund and Sliwka (2005, JEMS)Kragl (2015, JEMS), Kragl (2016, JITE)Kragl and Schmid (2009, JEBO)

all references at the endJenny Kragl (EBS) Workshop (IOEA) May 24, 2018 16 / 69

Outline

Envy in the Workplace: One-Shot Games

Individual Bonus ContractsGroup Bonus ContractsEnvy and Compassion in Tournaments

Envy in the Workplace: Repeated Games

Relational ContractsImpact of Envy on the Credibility ConstraintComparison of Different Incentive Schemes

Inequity Aversion in Vertical Bargaining

Other-Regarding Preferences in the Society

Conclusion and Discussion


Envy in the Workplace: Individual Incentive Pay

The Model

one-shot game between one principal and two agents i = 1, 2

agents are homogeneous and risk neutral

agents exert effort ei to produce verifiable output Yi ∈ 0, 1agents incur strictly convex effort costs c (ei ) withc (0) = c ′ (0) = 0

probability of realizing a ‘favorable’output:

Pr[Yi = 1|ei ] =: p(ei )

where p (ei ) ∈ [0, 1) is strictly concave and p (0) = 0agent i obtains payoff πi with fixed payment w and individualbonus b:

πi =

w if Yi = 0w + b if Yi = 1



Preferences

principal’s profit per agent is Yi − πi

agents observe mutual outputs and payoffs, but not efforts

agents compare their payoff to that of their co-worker and have adistaste for earning less (are envious)

agent i ′s utility:

Ui (πi ,πj , ei ) = πi − c(ei )− αmax πj − πi , 0 , i 6= j

where α ≥ 0 denotes the propensity for envy

as in Fehr and Schmidt (1999), inequity is specified as payoffinequality, which is suitable when participants are situated in asymmetric decision environment



Timing: one-shot game

1 the principal offers each agent the wage contract (w , b)2 each agent decides whether to accept or reject in favor of analternative employment that provides utility U0

3 if the agents accept the contract, they simultaneously choose theirrespective effort levels

4 outputs Yi and Yj are realized and payments are made



The Agent’s Problem

Payoff Matrix

Agent 1, 2 Y2 = 0 Y2 = 1Y1 = 0 w ,w w ,w + bY1 = 1 w + b,w w + b,w + b

agent i ′s expected utility:

E [Ui |ei , ej ] = w + p (ei ) b− c (ei )− α(1− p (ei ))p (ej ) b, i 6= jthe f.o.c. is given by (1+ αp (ej )) p′ (ei ) b− c ′ (ei ) = 0

by the implicit-function theorem, we finddeidα

> 0

⇒ incentive effect of envy: for any given bonus, the agent worksharder as he becomes more envious

in the Nash-equilibrium, we have ei = ej =: eJenny Kragl (EBS) Workshop (IOEA) May 24, 2018 21 / 69


The Principal’s Problem

the principal’s per-agent problem:

maxb,w ,e

VI (e,w , b; α) = (1− b) p(e)− ws.t. w + p (e) b− c (e)− α(1− p (e))p (e) b ≥ U0 (PC )

b (e; α) =c ′ (e)

(1+ αp (e)) p′ (e)(IC )

note that, by the incentive constraint (IC ), we havedbdα

< 0

the participation constraint (PC ) is binding in equilibrium:

CP (e; α) = w + p (e) b = c (e) + αp(e) (1− p(e)) b︸︷︷︸inequity premium

+ U0

⇒ inequity premium: for any given effort, the principal’s expectedwage cost are larger with envious than with self-regarding agents




the principal’s problem simplifies:

maxe

p(e)− c (e)− αp(e) (1− p(e)) c ′ (e)(1+ αp (e)) p′ (e)︸︷︷︸

inequity premium

− U0

Results:

⇒ for α = 0, the first-best solution is implemented

⇒ for α > 0, the first-best solution is never achieved

⇒ agency costs increase as agents become more envious

⇒ optimal contract is less powerful than first-best (no “selling the jobto the agent”)




second-best effort e∗∗ (α > 0) falls below first-best efforte∗ (α = 0)second-best profit falls below first-best profit



Main Results

1 incentive effect of envy strengthens incentives2 agency costs of envy lead to lower firm profits and a welfare loss

Intuition:

envious agents want to avoid the disutility due to envy

hence, they work harder than self-regarding agents to decrease theprobability of not getting the bonus

nevertheless, agents incur a utility loss due to the prospect of payinequality

the principal needs to compensate them by an inequity premium inorder to ensure participation

this raises wage cost and lowers profit under the optimal contract

results extend to the case of inequity aversion



Implications

Quote“The main function of internal pay structure is to ensure internal payequity, which is critical for good morale.” Bewley (1999, p. 82)

Concerns for fairness or equity can serve as an explanation for:

less powerful incentives than predicted by traditional modelswage secrecy normswage compression in firmsfairness normsgroup incentives (even if individual output measures are available;see the following model)


Envy in the Workplace: Group Incentive Pay

The Model

all assumptions as in the foregoing model except for wage contract

agent i obtains payoff πi with fixed payment wG and (per-agent)group bonus BYiYj paid contingent on both agents’outputwhenever paid out, the group bonus is paid to both agents

w.l.o.g., I focus on the symmetric Nash equilibrium w.r.t. theagents’efforts → B10 = B01 =: Bmoreover, let B11 = B + ∆

Bonus Matrix

Agent 1, 2 Y2 = 0 Y2 = 1Y1 = 0 0, 0 B,BY1 = 1 B,B B + ∆,B + ∆




agent i ′s expected utility:

E [Ui |ei , ej ] = wG + p (ei )B + (1− p (ei )) p (ej )B+p (ei ) p (ej )∆− c (ei ) , i 6= j

⇒ payoff inequity is avoided altogether⇒ externality of one agent’s effort on the other agent’s payoff→ free-rider problem

as before, in the Nash-equilibrium, we have ei = ej =: ethe f.o.c. yields the incentive constraint:

p′ (e)B + p′ (e) p (e) (∆− B) = c ′ (e) (IC )

⇒ envy has no effect on the agents’equilibrium effort⇒ the principal can implement an arbitrary effort level using any

bonus scheme (B,∆) that satisfies the constraint (IC )




the participation constraint is binding in equilibrium

→ expected per-agent wage cost involve no inequity premium:

CP (e) = wG + 2p (e)B + p (e)2 (∆− B) = c (e) + U0 (PC )

the principal’s per-agent problem:

maxe ,B ,∆

VG (e) = p (e)− c (e)− U0 s.t. (IC )

⇒ the first-best solution is implemented for any α ≥ 0⇒ no agency costs (no inequity premium)

⇒ altogether, when workers are envious, the principal favors the groupover the individual bonus scheme in the one-shot game


Envy and Compassion in Tournaments

Tournaments

rank-order tournamentspromotion tournamentsrely on relative performance (common shocks filtered out)are contractible even if output is not verifiable:firm commits to a fixed ordinal prize structure ex ante and cannotget out of paying the prize(s)

inequity aversion is highly relevant in tournamentsparticipants are typically identical ex ante and exert the same efforthowever, by construction, there will be a winner and a loser

⇒ payoff inequality cannot be avoided ex post⇒ inequity averse players will experience disutility under any outcome



The Model

basic model based on Lazear and Rosen (1981)

two identical risk neutral agents i = 1, 2

strictly convex effort costs c (ei )

agents produce output qi = ei + εi

εi denotes the random term (iid across agents)

G (·) denotes the (symmetric) distribution function of composedrandom variable εj − εi and g(·) its densityagents have reservation utility U0the agent with the higher output obtains the winner prize wloser gets loser prize l < w , denote prize spread by ∆ = w − l

πi =

l if qi < qjw = l + ∆ if qi > qj

, i 6= j



The Agent’s Problemagents are inequity averse with α > β ≥ 0:Ui = πi − c (ei )− αmax πj − πi , 0− βmax πi − πj , 0 , i 6= jin case of winning, agent i obtains:

Ui = w − β∆− c (ei )in case of losing, agent i obtains:

Ui = l − α∆− c (ei )agent i’s probability of winning is:

Pr (qj < qi ) = Pr (ej + εj < ei + εi ) = Pr (εj − εi < ei − ej )= G (ei − ej )

accordingly, agent i’s probability of losing is:

Pr (qj > qi ) = 1− G (ei − ej )Jenny Kragl (EBS) Workshop (IOEA) May 24, 2018 32 / 69



agent i’s expected utility becomes:

E [Ui |ei , ej ] = G (ei − ej ) (w − β∆− c (ei ))+ (1− G (ei − ej )) (l − α∆− c (ei ))

in the Nash-equilibrium, we have ei = ej =: ethe f.o.c. is given by:

(1+ α− β) g (0)∆ = c ′ (e)

⇒ equilibrium effort is increasing in α but decreasing in β

⇒ (dis)incentive effect of envy (compassion)

⇒ altogether, by α > β, there is an incentive effect of inequityaversion: for given ∆, a tournament among inequity averse agentsleads to higher efforts than one among self-regarding agents




in equilibrium, agents win (and lose) with probability 0.5

they suffer a utility loss in either case

the principal’s expected wage cost per agent are:

CP (e; α, β) = c (e) + (α+ β)c ′ (e)

2 (1+ α− β) g (0)︸︷︷︸inequity premium

+ U0

⇒ inequity premium: for any given effort, the principal’s expectedwage cost are larger than with self-regarding agents

⇒ for α > 0 and β ≥ 0, the first-best solution is never achieved⇒ agency costs of inequity aversion lead to suboptimal efforts and

profits



Extension: Limited Liability

suppose that agents are wealth-constrained so that their wagemust be non-negative in any state

additional non-negativity constraint (l ≥ 0)the expected wage costs per agent are then given by:

max

c (e) + (α+ β)c ′ (e)

2 (1+ α− β) g (0)+ U0︸︷︷︸

(1)

,c ′ (e)

2 (1+ α− β) g (0)︸︷︷︸(2)

two cases:

(i) (1) > (2): the participation constraint is binding (results as before)(ii) (2) > (1): the non-negativity constraint is binding ⇒ agents earn

an informational rent



Extension: Limited Liability

in case (ii), the expected wage costs per agent are given by 12∆:

CP (e; α, β) =c ′ (e)

2 (1+ α− β) g (0)

⇒ expected wage cost are lower with inequity averse than withself-regarding agents (α > β)

intuitively, a lower prize spread is needed to induce effort, therebyreducing rent payments

rents are paid if c (e) + U0 < (1− α− β) c ′(e)2(1+α−β)g (0)

if α and β are small (utility loss due to inequity aversion is small)if g (0) is small (impact of luck on the outcome of the tournamentis large) → large prize spread is needed


Competitiveness in Tournaments

Extension: Joy of Outperforming

suppose that β < 0 → agent derives pleasure from being better offthan his co-worker

together with α > 0, such preferences are known ascompetitiveness, pride, status concerns, or spitefulness

recall the incentive constraint:

(1+ α− β) g (0)∆ = c ′ (e)

⇒ agents work even harder than inequity averse agents

intuitively, the additional utility gain from winning provides extrawork incentives


Competitiveness in Tournaments

Extension: Joy of Outperforming

recall the expected wage costs of the principal:

CP (e; α, β) = c (e) + (α+ β)c ′ (e)

2 (1+ α− β) g (0)+ U0,

⇒ with β < 0, wage costs are smaller compared to inequity aversion

intuitively, the expected joy of outperforming counteracts the expectedloss due to envy

(i) if α > |β| → CP (e; α, β) > c (e) + U0 → e∗∗ < e∗

(ii) if α = |β| → CP (e; α, β) = c (e) + U0 → e∗∗ = e∗

(iii) if α < |β| → CP (e; α, β) < c (e) + U0 → e∗∗ > e∗!

intuitively, in case (iii), the expected joy of outperforming exceeds theexpected loss due to envy so that the inequity premium gets negative


Inequity Aversion in Tournaments

Results

tournaments provide strong work incentives

at the same time, they lead to large pay inequality

for inequity averse workers, incentives are strengthened comparedto self-regarding workers

this may be beneficial for the firm when agents receive rents

in general, however, the firm’s total wage costs are increased bythe presence of inequity aversion

impact on the firm’s optimal promotion policies

in vertical promotions, inequity aversion raises wage costslateral promotions may reduce the relevance of inequity aversion


Envy in the Workplace: Incentive Pay in One-Shot Games

Summary

in one-shot games, explicit incentive contratcs rely on verifiableoutput (performance) measures

envy and inequity aversion affect the firms’choice of optimalincentive schemes

+ incentive effect of envy under pay inequality

− inequity premium raises wage costs

⇒ agency costs of inequity aversion lead to lower profits

group incentives rule out pay inequality→ preferable in one-shot games with inequity averse workers

tournaments imply the strongest degree of pay inequality→ least desirable

but: tournaments are contractible even if output is non-verifiable


Envy in the Workplace: Relational Contracts

assume that output is not verifiable (performance cannot beassessed by third parties such as a court)

⇒ explicit incentive contracts cannot be implemented

however, relational incentive contracts (also implicit contracts)can be implemented in repeated games

realistic for employment relationships → long-term interaction offirm and workers

relational contracts are sustained as reputational equilibria if theyare self-enforcing

⇒ credibility constraint requires the firm to be credible not todeviate from the agreement:

→ the firm’s gains from reneging on the contract must fall short ofthe discounted gains from continuing the relational contract



Overview: Credibility Problem and Payoff Inequity

Payoff Inequity Credibility Problem

Individual Bonus yes (sometimes) yes

Group Bonus no yes

Tournament yes (for sure) no

→ Question: Which incentive scheme is optimal when output is notverifiable and workers are envious?

→ firm’s interest rate affects the severity of the credibility problemand hence the results



Credibility Constraint

we embed the initial model into an infinitely repeated gamebetween a long-lived principal and an infinite sequence of twoidentical short-lived agents i = 1, 2

output Yi ∈ 0, 1 is non-verifiable but observed by both parties(but no outsiders)

the principal promises to pay a bonus upon good performancebut the contract cannot be enforced in court

agents play a Grim trigger strategy (see, e.g., Baker et al. 1994)

→ reneging on the promised bonus once, destroys the principal’sreputation in the labor market

no agent will believe her to fulfill the contract in the future



Credibility Constraint in the Individual Bonus Contract

per-agent profits in the relational individual bonus contract:

V ∗I (r , α) := maxeVI (e; α) s.t. (CC)

fallback profit is zero: agents exert zero effort if trust is brokencontinuation profit: present value of per-period profitsr denotes the principal’s interest rate

⇒ credibility constraint:

b (e; α) ≤ VI (e; α)r

(CC)

→ for given effort, a small interest rate, a small bonus, and a highper-period and worker profit soften the constraint

⇒ impact of envy on credibility is ambiguous:+ incentive effect of envy facilitates credibility− inequity premium effect impedes credibility




⇒ interpretation of the principal’s interest rate r :

opportunity cost (discount rate)measure of patience, dependency, or trust (Hart 2001)interpretation in terms of the likelihood that the firm disappearsfrom the market (economic stability, market prospects)

rb (e; α) ≤ VI (e; α) (CC)

r ≤ r : (CC) is not binding→ principal implements the same contract asunder verifiability

r < r ≤ r : (CC) is binding → principal implements lower effort toreestablish credibility and profits decrease

r > r : (CC) cannot be satisfied any longer → relational contracts areinfeasible and profits drop to zero



Results: Envy in the Individual Bonus Contract

in the foregoing figure, both curves shift downwards as α increases

it can be shown that, under some condition, it holds dr/dα > 0

⇒ the interest rate for which relational contracts become infeasible isincreasing in envy

⇒ envy has a credibility-enhancing effect if

incentive effect outweighs inequity premium effectVI (e; α) reacts less strongly to an increase in envy than b (e; α)precision of the output signal is largeelasticity of effort costs is small

in the following figures, it holds that dr/dα > 0

let αH > αL



Profits in the Relational Individual Bonus Contract

r (α) rr(αL) r(αH) r(αL) r(αH)

VI* (r;αH)

VI* (r;αL)

⇒ For a range of suffi ciently small interest rates, the situationresembles that under verifiability; the principal is better off withless envious (or self-regarding) agents.



Profits in the Relational Individual Bonus Contract

rr(αL) r(αH) r(αL) r(αH)

VI* (r;αH)

VI* (r;αL)

r (α)

⇒ For any interest rate r > r (α), the principal is (weakly) better offwith more envious agents.



Credibility Constraint in the Group Bonus Contract

per-agent profits in the relational group bonus contract:

V ∗G (r) := maxeVG (e) s.t. (CCG )

in the group scheme, the firm is credible if and only if:

maxB,B + ∆ ≤ VG (e)r

(CCG )

→ optimal credibility-constrained group scheme:

scheme with lowest maximum bonus among all possible (B,∆)depending on p (e), the principal sets:

either (0,∆): pays a bonus only if both agents are successful or(B, 0): pays a bonus if at least one agent is successful



Credibility Constraint: Individual vs. Group Bonus Contract

lhs (bonus):

for any e, α ≥ 0, the size of the incentive-compatible group bonusexceeds the size of the individual bonus

the difference is increasing in α

intuition:

(i) free-rider effect: B,∆ > b even if α = 0(ii) incentive effect of envy: b is deceasing in α

rhs (continuation profits):

for α = 0, profits coincide (first-best)

for α > 0, profits in the individual bonus contract fall below thosein the group bonus contract

intuition: inequity premium effect of envy



Individual vs. Group Bonus Contract: Self-Regarding Agents

rI(α = 0)r

VI*(r;α = 0)VG*(r)

rG rI(α = 0) rG

⇒ For α = 0, the principal (weakly) prefers the individual bonuscontract to the group bonus contract for any r .



Individual vs. Group Bonus Contract: Envious Agents

rI(α > 0)r

VI*(r;α > 0)

VG*(r)

rGr (α)

⇒ For α > 0, the principal is better off using a group bonus for arange of suffi ciently small interest rates.



Individual vs. Group Bonus Contract: Envious Agents

rI(α > 0)r

VI*(r;α > 0)

VG*(r)

rGr (α)

⇒ For α small, the principal is (weakly) better off with an individualbonus scheme for any r > r (α).The result extends to large α ifdr/dα > 0.



Individual vs. Group Bonus vs. Tournament: Envious Agents

rI(α > 0)r

VI*(r;α > 0)

VG*(r)

rGr1 (α)

VT*(r;α > 0)

r2 (α)

⇒ For α > 0 and suffi ciently high interest rates, the principal realizespositive profits only with the tournament contract.


Envy in the Workplace: Further Results

in a more general model with unconstrained bYiYj , pay inequalityis measured by (b10 − b01)

captures the foregoing models as special casesyields richer but qualitatively the same results

results extend to inequity aversion (recall that α ≥ β)

incentive effects is weakened (by compassion)inequity premium is raised (additional disutility of compassion)

→ pay inequality is less likely to facilitate relational contracts

results are strengthened by joy of outperforming (β < 0)

incentive effect is increasedinequity premium is reduced (utility of outperforming counteractsdisutility of envy)

→ pay inequality is more likely to facilitate relational contracts→ if α < |β|, pay inequality unambiguously facilitates relational

contracts


Envy in the Workplace: Further Results

results extend to limited liability of workers (wealth constraints)

if workers earn rents, size of the rent determines wage costs andcontinuation profitsenvy yields smaller incentive pay, smaller rents, and higher profit

→ pay inequality unambiguously facilitates relational contracts



Wages vs. Profits in Germany



Supersize our wages! Hundreds of fast-food industry workersacross the U.S. join strike demanding $15 an hour pay.

"The workers want to form unions [...] and bargain for more money. [...] a community

organizer in St. Louis, said local employees of McDonald’s and Wendy’s can’t make it on the

salaries. ‘Unless we can figure out how to make highly profitable companies pay a fair wage

to their workers, we’re just going to watch them pull all the blood, sweat, tears and money

out of our communities.’ [...] the so-called ’McJobs’[...] are known for their low pay and

limited prospects. In contrast, McDonald’s profits totaled $5.47 billion in 2012." [Reference:

Daily Mail (online), 29 August 2013]Jenny Kragl (EBS) Workshop (IOEA) May 24, 2018 59 / 69


The Modelone-shot game between firm and workerworker dislikes net income differences D for any output level Q:

U (Q,W , e) = W − c (e)− γG (D)

G

D

D = [Q −W ]− [W − c (e)]G (D): disutility due to inequity aversion (asymmetric)γ: worker’s individual propensity for inequity aversion



Main Results1. the welfare-maximizing contract stipulates an equal sharing rule forany output produced (note the difference to the first-best contractwith self-regarding workers)

2. the profit-maximizing contract (take-it-or-leave-it offer) solves atrade-off regarding expected wage costs:

higher pay directly raises wages costs but indirectly lowers them byreducing the inequity premiumoptimal contract leads to agency costs of inequity aversion

3. the optimal contract with Nash-Bargaining:

leads to a more egalitarian distribution of surplus than bargainingwith self-regarding workersleads to higher total welfare than the profit-maximizing contractapproaches the welfare-optimal contract as the parties’bargaining powerconverges



Idea

until now:

interpersonal comparisonsimpact of inequity aversion on contracts, effort, and welfare at themicro level

motivated by the growing interest in inequality triggeredparticularly by Piketty (2014), we consider a new dimension

→ potential societal impact of attitudes towards inequality

we look at relative societal rankingsinitial wealth matters for the (dis)utility effects of inequality

⇒ people care about their income and wealth relative to theeconomy’s average



Inequality Preferences

we specify a person’s disutility of inequality as:

f (ω,Ω) = γ

1−(ω

Ω

)1+

(ω

Ω

)α

, α ∈N

ω is the person’s total ex-post wealth (including income)

Ω is the societal average ex-post wealth

γ ≥ 0 reflects the sensitivity towards inequalityα captures the type of preference:

(a) an even α reflects inequality aversion(b) an odd α represents competitiveness



Inequality Preferences

⇒ attitude towards inequality is endogenously asymmetric:a given income difference affects persons with income below averagemore than those with income above average



Questions

How do such attitudes affect economic performance (e.g. GDP)?

Do societies characterized by inequality aversion generate dynamicforces that help reduce inequality?

The Model

simple static general-equilibrium model

economy is populated by firms and workers

moral-hazard environment with individual incentive contracts

workers have the same preferences but differ in their initial wealth(poor, rich)

⇒ (dis)utility effects of inequality are more pronounced for the poor

important: inequality preferences are valid when employed orunemployed ⇒ outside option becomes endogenous



Results (work in progress)

⇒ inequality aversion tends to generate even more inequality butleads to higher output and firm profits (also true for competitivepreferences)

the poor work always harder than the rich but earn always lower wages

compared to self-regarding workers, the envious poor work harder andturn out to be cheaper to employ

the rich work harder if competitive but less if inequality averse

the rich become cheaper to employ if competitive but more expensive ifinequality averse (but less so than the envious poor)

under utalitarian social preferences, “perfect” redistribution iswelfare-enhancing for both types of preferences

however, the rich oppose redistribution in either case; even wheninequality averse they prefer to keep their wealth rather than give it tothe poor


Conclusion

effi cient design of labor contracts is affected by differentdimensions of the employment relationship

social preferencesavailable performance measures and incentive contractsopportunity costs of the firm and employment duration

joint performance pay is more effective:in the presence of fairness concernswhen explicit contracts are possiblein relational contracts in stable industries or long-term employment

individual or relative performance pay are more effective:if relative pay comparison is not relevantif relational contracts are important due to non-verifiability problemswhen firms are subject to credibility problems

incentive pay does not only raise work motivation but alsoredistributes productive surplus to workers, thereby meetingfairness concerns


Discussion

definition of other-regarding preference across people andrelationships

type, strength, heterogeneity

relevance of context

social, cultural, institutional contextreference groupsocial distance (friends, relatives, co-workers, bosses, strangers)

→ are the deviations from rationality and pure self-interest large andsystematic enough to generally apply new decision theories?

→ how can these models be applied systematically?

implications for wage policies and transparency

implications for organizational architecture

implications for welfare and regulation


Thank you for your attention!

Jenny KraglEBS Universität für Wirtschaft und RechtDepartment of Management & Economics

[email protected]


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